A noise about silence
The much delayed reform of the pension system is finally due to be implemented at the beginning of 2008. Not a moment too soon. While the date has slipped continuously over the years the urgency for reform grows in sympathy, as the fortunes of the new generation of pension funds that was intended to boost second pillar provision remain lacklustre.
The new funds came into being around the turn of the millennium following legislation originally enacted in 1993 but whose guidelines remained elusive for a full five years after that. Until 1993 second pillar provision had been more the privilege of professional classes. Those funds are now known as ‘preesistente’ or, literally, pre-existing. “The preesistente still have three times the assets of the new funds,” says Piero Marchettini, partner at Adelaide Consulting. “The problem is that the new funds have been promoted by the unions and government and have not been allowed full market freedom.”
Maria Cristina Guerini, responsible for pension fund mandates at Milan-based San Paolo IMI points out that pension funds are still seen as a privilege and their importance has not been appreciated by the majority of workers. “The new sector funds have 2m members compared with a potential of 20m,” she says.
One vital element of the pension reform will mean that the severence pay or TFR of workers who do not express a preference as to its subsequent use – known as ‘silenzio assenso’, or silent assent – will automatically be transferred to a pension fund, rather than staying with the former employer.
The general feeling is that the transfer of the TFR to pension funds will be key to the success of the second pillar in general and the new funds in particular. “Without this the new pension funds will remain very small,” says Paolo Sardi, partner at Milan-based consultancy E Capital Partners Indices. “Size represents a constraint in terms of being able to improve investment strategy and access to more sophisticated solutions.”
The new reform which is due to be implemented in 2008 has brought new fiscal incentives. Pension payments were subject to general taxation,” says Renato Guerriero, head of the Milan office of Dexia AM. “That is why the preesistente funds still have three times the assets of the new funds. Now the level of taxation will be 15%, and just 9% if the member has contributed for 35 years.”
But in spite of the reform the tax benefits for the new sector funds (also known as fondi negociali or fondi contrattuali) are, in some respects, “still inadequate,” according to Sergio Albarelli, senior director at Franklin Templeton. “At the moment contributions up to 2% of salary are tax deductible; due to the financial situation of the government it will be a long time before we can invest more.”
One major step forward in making
the second pillar more user-friendly has been the decision to unify regulation. COVIP, which already regulates the preesistente and the new funds will now oversee the insurance players as well. “If one controller is in charge of everyone that will make the offerings more comparable and therefore increase competition,” says Guerriero.
Sardi adds: “Pension funds will have to compete with insurance and banking offerings on efficiency, marketing and performance, so size is will be an issue.”
Pension funds must, by law, offer a guaranteed investment line which mirrors the TFR, that is a guaranteed return on 75% of ‘inflation’ plus 1.5%. “If the pension fund must offer the same guaranteed return, why move the TFR from the company to the pension funds?” asks Michael Atzwanger, director of consultants PensPlan Invest in Bolzano. “It makes no sense. Most pension funds and of course most asset managers are therefore focusing now on how to produce guaranteed rate for returns for pension funds rather than on generating the best possible returns.”
There are concerns about the legitimacy of this compulsory TFR-mirroring option. “This cannot be ruled by law - it must be a market request,” says Giordano Lombardo, deputy CEO at Pioneer Investments. “From a pure technical point of view the only entity which can guarantee capital and the yield is the state. From a purely theoretical point of view if a manager offers a product in line with the TFR he must disclose the cost of the guarantee.”
Most estimates for the annual value of TFR inflows to the pension system range between €12bn and €15bn. But Lombardo is more cautious. “I think the TFR will bring in around €6-7bn,” he says. “Workers are quite reluctant and the reason is that, not knowing enough about pension funds, they prefer to stay where they are. It is up to the industry to explain defined contribution funds to the workers so there is a huge information challenge.”
Currently people receive as much as 80% of their average earnings from the social security system INPS. “But this ratio will be much lower in the future with the new DC system,” says Fabrizio Meo, managing director of ING IM in Milan.
He adds: “I think that the transfer of the TFR to a pension fund should be made mandatory. This is a tough statement, but the government should realise that people are not fully aware of the need for additional provision and, very likely, still think that the replacement ratio of the first pillar is 80% for everyone.”
Awareness of the pension issues appears to be critically deficient among the Italian public. “The best selling products have 70% bonds – even for younger members of pension funds,” says Marco Baldassini, director at the Milan office of Lazard AM.
“We need to spend a lot of time educating investors about how to get ready for their retirement,” says Rafael Febres-Cordero, managing director of Fidelity International for southern Europe. “This is where I see the biggest challenge and the biggest opportunity.”
The typical public attitude to the TFR and what to do with it is an excellent example of behavioral finance, according to Alessandro Gandolfi, responsible for institutional clientele development at San Paolo AM. “People are worried about what they have, not about what they don’t have or could have.”
He adds: “With the increase in interest rates the TFR has become less interesting. But for the uneducated worker the TFR is a guarantee, so we have to make him understand that, if we assume that interest rates will not remain low, as was the case in the past, the TFR return will not be interesting as a retirement product.”
The issue of education – or rather the
lack of it – extends to those already enrolled in a sector fund. Most funds offer several investment options to their members, known ‘multicomparto’. “This makes the issue of member education so big,” says Guerriero. “Sector funds have no bank or asset manager, they not distributed by financial advisers so there is a real need. So sector funds should get advisers, especially if the reform brings more competition between pension funds. If asset managers are doing the educating there is a conflict of interest.”
Sector funds came to market bearing very strict investment limits. “I think hedge funds should be allowed as an asset class because it would stabilise market trends,” says Marzio Zocca, head of institutional clients at Azimut in Milan. “Furthermore, it is oriented more to total return which is missing in the market. There is too much bureaucracy in the way pension funds are managed although there is a big need for control.”
The problem of strict investment limits is compounded by further cultural issues. “The industry pension fund approach is very conservative especially unions which do not want to give the impression to their members that they are speculating with their money,” says Albarelli. “So they have lots of fixed income and cash; equities are not seen as the way to generate long term higher returns.”
It is also very difficult for sector funds to introduce UCITS. By contrast, the ‘preesistente’ funds have far more lax investment limits and can invest in assets such as hedge funds and real estate. “Social security institutions such as ENPAM, the doctors’ fund, manage much better,” says Guerriero.
The investment limits for sector funds appear to have sound origins. “They were useful at the beginning because there was not much financial competence at board level,” says Sardi. “However there is now a need for much more flexibility as funds start to consider alternatives. At the moment there are no sophisticated solutions to manage the market risk.”
The mentality of the Italian investor is indeed evolving. “They look at long-term planning and we see a more demanding investor in terms of choice which has driven a move towards more open architecture,” says Febres-Cordero. “They are also increasingly demanding more predictability in terms of fund performance in line with their risk profile.”
The sophistication is particularly visible among the ‘preesistente’ funds. “A lot of products and strategies are becoming soup of the day for some investors,” says Baldassini. “These include absolute return, hedge funds, emerging market equities and bonds, as well as niche strategies such as closed-end funds.”
He adds: “Investors have become more sophisticated with the hiring of local and international investment consultants and talented investment teams. The largest pension funds have hired from asset managers. Now we need more political drive to get from a flag on the map to a more developed market.”
While the public and their pension funds struggle under the weight of responsibility, Italian asset managers are struggling under the weight of competition from foreign asset managers “because of a lack of efficiency, high costs, and modest returns,” according to Atzwanger. “Italian asset managers are not used to globalisation, since, with the exception of Pioneer, they do not offer asset management services outside of Italy.”
Nonetheless domestic managers still hold the bulk of total institutional AUM. Growing specialisation will further stimulate competition, as Meo explains: “The increase of AUM and the move to a multicomparto system, pension funds will start to think more about specialised assets and specialised portfolio managers.”
Max Nardulli, managing director at Goldman Sachs AM with responsibility for Italy but based in London stresses that Italian managers have a size and scale issue. “There was a big problem four or five years ago,” he says. “But a lot of outsourcing and the cross-border M&A activity will improve efficiency, reduce cost and improve returns,” he says. “Some Italian fund managers have a limited size but continue to manage every type of asset class in-house. No asset manager can do everything very efficiently.”
Is enough being done to address the size and scale issue? Lombardo thinks not. “There is a lack of entrepreneurial decision making on the part of banks regarding whether they want to stay long term in asset management, and if so would they consider a consolidation,” he says, and adds: “Some asset managers are providing advisory on asset allocation and risk management and the general perception among banks is that this is the right approach.”
The problems facing Italian managers are considerable, as Guerriero points out. “All Italian funds managers are seeing large outflows,” he says. “Two years ago Italian asset managers lost €20bn - the worst year since records began. Under fiscal law institutions have to pay tax on gains accrued and not cashed in on Italian funds, but in the case of, say, UK, French or Luxembourg funds only have to pay on realised return. This is a big issue and it is destroying the Italian fund industry – everyone is aware of the problem but nobody is doing anything, hence the outflows.”
The second reason for the loss of market share experienced by Italian managers, Guerriero explains, is linked to a strategic mistake by their owners, the banking groups. “They created asset management houses but saw them as factories – not a modern factory but more like something of the industrial revolution,” he says. “They invest the minimum and take out the maximum - there is no innovation, research or investment, but 90% of revenue is paid to the parent company.”
But while Italian managers might be down, they’re not out. “We are seeing a huge restructuring among Italian managers who are investing in more sophisticated investment processes,” says Sardi. “They are also focusing more on specialised strategies, selecting what they can do better.”
He adds: “In the present environment where mandates are in the €10-50m range foreign managers would not be interested. But going forward, with new money coming into the market, and bigger ticket items becoming available, local managers will face more competition from foreign managers.”
Some players seem to be striving to adapt. Local managers are starting to focus on what they are good at like European fixed income,” says Nardulli.
Baldassini goes further. “Managers are outsourcing not just satellite asset classes but also mainstream asset classes, in response to investor demand. They are also more willing to share knowledge of clients. But this is still in the making.”
Competition is forcing another key issue. Governor Draghi has said that Italy’s independent asset managers are important for the future, and that only asset management without conflicts of interest will perform on international levels. “The value of independence is high and growing as most foreign managers are independent,” says Zocca, who agrees that Azimut’s status as one of Italy’s only independent asset managers was a competitive advantage when it moved into the institutional market.
The theme of independence certainly seems to be gaining status. In July San Paolo IMI was due to be transferred to a holding company Eurizon which also contains the group’s private banking operation Fideuram and its insurance business. In the autumn and then minority stake of holding company Eurizoni will be spun off. “This is a step towards a more independent asset management business,” says Gandolfi.
But we should not forget that independence can be interpreted more broadly. “I agree 100% about the need for independence but we also have to agree on what independence means,” says Lombardo. “Asset managers owned by banks can also be independent provided they have a strong focus on governance.” Pioneer Investments is owned by Unicredito.
Separation of the asset management function is moving to the centre ground, with some novel ideas. “We think the Israeli model is a good one,” says Nardulli. “The model is based on the separation of the bank and asset management business. Also, the level of rebate to distributors is equal for all players – but we are far from that point.”
Fees are a major preoccupation for Italy’s institutional investors and their asset manager suppliers. According to Meo, the trend is positive as clients begin to realise that there is a fair price to pay for services. However, even today cost represents a key point of the overall management selection decision which, he says is “far too high.” According to Guerriero, fees charged by sector funds in 2004 were around 14 basis points. “Boards of sector funds are very concerned about fees,” he says. “But things are changing because price is no longer always the first factor.”
Pension funds have been accused of squeezing the pricing. “Asset managers didn’t fight this enough, so mandates were awarded at a very depressed fee level,” says Zocca. “Some asset managers offered low fees to get a foothold in the market. However the low fee level this was then assumed as the benchmark for the future.”
The fee levels have serious implications for competition. “We decline to tender for some beauty contests because we feel that the current level of fees doesn’t cover the cost of tailoring the service and administration,” Zocca continues.
“The ‘preesistente’ funds, with more flexibility in their investment strategies, have a better understanding of the need to pay more for certain classes of assets and service levels. The beauty contest process is less heavy and the levels of remuneration are higher. The fee levels of the sector funds are not sustainable in the medium to long term.”
Marchettini points to further competitive concerns arising from the pricing issue in that the focus of industry funds on cost has been “a disincentive for foreign managers to enter the market”.
But things are looking up. “Pension funds will become more experienced,” says Meo. “Some are looking more at performance related fees.”
Related to fee levels is the preoccupation of institutional clients with the segregated mandate, even for small mandates of under €5m – even as little as €1m. “The mania of having segregated can be catered for only by Italians who can offer the service for a small marginal cost,” says Albarelli. “Foreign managers are not willing to do this so cheaply and for such small AUM. This was a huge advantage for Italian managers.” But here too things are looking a little brighter. “Consultants are helping to move clients towards funds,” says Nardulli. “Four to five years ago clients would only consider segregated funds; now they are more and more happy to invest directly in funds.”
The issue of competing for business has been further complicated by a distinctly non-user-friendly application process. “There is too little transparency in the RFP process – Italian managers are winning most of the business and nobody understands why,” says Atzwanger. “Italian managers are helped by the amount of bureaucracy: local managers have better connections with the authorities. Regulations are often interpreted in a way which favours local asset managers in getting business.”
It is not just foreign managers that suffer here. “If we are not selected usually we don’t know why,” says Zocca. “Sometimes all we get by way of feedback is ‘sorry you have not been selected’, even when we thought we had answered well. We didn’t know whether the problem was organisation, process or cost. Furthermore, rules often do not clearly state what the selection criteria are. Some questionnaires are too complex and did not give an opportunity to explain what we are good at.”
But a more open approach is taking root. “The RFP process is becoming more transparent because people are finally starting to hire consultants,” says Nardulli. “Previously, decisions were made in a very political way.”
Sardi points to the fact that there are several foreign managers working for sector funds. Furthermore, Credit Agricole acquired Nextra and ABN Amro acquired Antonvenita. “So the Italian pension fund market is not a black box,” he says.
But the complexity of the system is still a problem. “There are too many regulations,” says Lombardo. “New funds need approval from COVIP, the Bank of Italy, and Consob, the Italian SEC. It is difficult to get approval for new funds. In Luxembourg approval for a new fund takes two months; here it takes somewhat longer. If we had a single body like FSA in the UK that would be great.”
In contrast with a rather stale fund approval system is an indication of fresh thinking among investors in the form of increasing sensitivity about SRI. “Existing and new funds are looking at investing in SRI driven partly by issues like Parmalat – need to demonstrate more transparency,” says Sardi.
The 2008 law will also contain a provision which will require funds to disclose what they are doing with SRI and what the policy is.
Amid so many encouraging signs the challenges remain considerable.